Crude Oil Prices

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Crude Oil Prices

25 May 2008, 4:25 pm
by Quant Investor

Next week, I plan to start lightening up on some of my energy holdings. There are both bullish and bearish arguments on future crude oil prices, but I think the bearish case may soon start to win out. Some of the recent price appreciation is merely a reflection of the weak US dollar, but a lot of the move is also due to speculative sentiment. There have also been erratic price moves as many crude oil forward months have moved from backwardation to contango back to backwardation again.

Let's start with some of the bullish arguments-
1) "The trend is your friend". There is no question that most momentum-based trading models are long crude oil and will stay long unless there is a sharp correction.
2) A Goldman Sachs analyst has forecast higher prices.
3) There are periodic stories about long term supply problems.
4) Long only commodity funds are causing a lot of the move which may not be over yet.

But here are some very strong potential bearish arguments, some of which can have a sharp negative impact on the crude oil price:

1) Raising the margin requirements: It is easy to make the case that the margin requirement for the crude oil futures contract has simply not kept up with the price increases. Each crude oil contract represents 1,000 barrels. At around $132/barrel, one contract is worth $132,000. But the maintenance margin is only $7,250. That’s over 17 to 1 leverage. The commodity exchanges are sensitive to pressure from Congress, and will most likely raise the margin requirements in the near future. This could have a dramatic downward effect on prices.
(Remember silver and the Hunt Brothers in 1980).
2) Lower limits on the number of contracts any single institution can buy.
3) Pass legislation to limit commodity swaps that bypass commodity futures contract limits.
4) I'm starting to read that more countries are reducing subsidies of crude oil prices. This will soon lead to a decreased demand from parts of the world where consumers have been shielded from the higher prices. Many of these countries have huge populations (e.g. India, Indonesia etc.).
5) The US dollar has been weak because of the previous interest rate cuts. But the cuts seem all but over now. The rest of the world will soon need to cut interest rates to catch up with the US. This will lead to a stronger US dollar and weaker crude oil prices in dollar terms.

By the way, a good free web site for following crude oil and other commodity prices is http://www.ino.com/